Labour must modernise industry and back regional growth if it is not once again to preside over a slump, argues Colin Hay.

Now that Labour has won the election, the debate over the party's self-styled "modernisation" has become more than an internal matter. It concerns the nature of the British state and economy, and its outcome will determine Labour's ability to cope successfully with government.

Labour has chosen to present itself as a more competent manager of the Thatcherite legacy than the Conservatives. This might be seen as the pragmatic response of a party lacking either a clear diagnosis of the British malaise or the vision to project a distinctive alternative. But it contains great dangers. Accepting these terms restricts a Labour government to techniques and policies which bear the stamp of free-market ascendancy. It also constrained Labour's economic critique during the election campaign to the accusation that the Major government had, at worst, been incompetent in economic matters. This ducked the more fundamental analysis - that the Conservatives had been attempting the impossible in trying to manage the post-Thatcher settlement with chronically depleted strategic resources.

The danger is that Labour has won at the cost of consigning itself to futile attempts to manage the contradictions of a state and economic regime in an advanced state of decay. The Independent has suggested, drawing on official Treasury documents: "17 years of Tory taxing, borrowing, selling off and spending (have) cost Britain Pounds 3,204bn ... The Government is literally bankrupt - with net wealth declining from nearly Pounds 200bn in 1979 to Pounds 152bn at the end of 1995".

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The budget deficit is projected to rise to 5 per cent of national income by the turn of the century. To protect against the capital flight likely in such a scenario, Labour chancellor Gordon Brown is faced with the equivalent of a 7-8 pence increase in the basic rate of taxation, or the equivalent level of welfare retrenchment (and that, it should be noted, would only reduce the budget deficit to 2.5 per cent of national income, a level outside the Maastrict convergence criteria). All of which merely points to the difficulties confronting the new Government and the rather cynical nature of the pre-election skirmishes on taxation.

The challenge this presents is considerable. To avoid inheriting responsibility (and culpability) from the Conservatives for the looming crisis (as it did in 1974), Labour must offer a compelling diagnosis of the "State we're in" and its origins. Otherwise Labour risks implicating the party (once again) in the disintegration of a deeply contradictory settlement. This would give the Tory opposition an opportunity to reimagine its political project, presenting itself as the only party capable of the degree of decisive intervention required in a situation of economic and political crisis.

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In looking for answers Labour might benefit from rediscovering the courage of its former convictions. Not by a return to "old" Labour themes, but from the implicit growth strategy outlined most recently by Labour's Industry Forum.

The forum's 1994 industrial policy manifesto Winning for Britain challenged the ascendancy of macroeconomic conservatism and neo-liberal economics. It emphasised industrial strategy, supply-side intervention, a more active regional policy and, above all, the subordination of fiscal austerity to industrial modernisation. So far these ideas have been sacrificed to the macroeconomic rectitude espoused by Gordon Brown's Treasury team. But their revival could provide the Labour Government with the distinctive economic vision it needs.

This vision must identify the conditions for restoring the competitiveness of the British economy. It would promote complementary but potentially highly differentiated patterns of regional growth, sustained by flexible regional institutions which might eventually replace the present regional quangocracy with the principle of regional stakeholding.

British industry has to be encouraged to think long-term if its competitiveness is to be restored through modernisation and strategic investment in new technologies, "human capital" and new management techniques. This requires a fundamental change in the mind-set of British industrialists and a transformation of the institutions within which such a mind-set has become entrenched.

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The centre would promote cooperation between regional economies, militating against and, if necessary, outlawing mutually destructive regional competitive strategies, such as regulatory undercutting to attract inward investment. It should facilitate the access of the British regions to European funds and to an emergent "third tier" of trans-regional governance within Europe.

It is perhaps optimistic to hope that new Labour will embrace these ideas. The contemporary context, like that of the late 1970s, is one of profound, protracted and widely experienced state failure, social dislocation and economic contradiction - "looming bankruptcy". This presents new Labour with a clear, but unenviable choice. Does it want to project itself as the party of fiscal rectitude and managerial competence - the natural heir to the legacy of Major? Or does it seek to diagnose the crisis of the British state and argue the case for a decisive break with a decaying regime and an obsolescent economic paradigm?

Recent experience suggests that, so far as it has recognised the choice, it is likelier to choose the first option. The cost may well be British social democracy itself.

Colin Hay teaches in the department of political science at the University of Birmingham and is a visiting fellow at Harvard University's center for European studies.

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